1. Payouts from 401(k) Plans
October 2, 2006

2. By the end of this lecture, you should be able to:
Explain payout options from 401(k) plans
Discuss the importance of longevity risk in planning retirement withdrawals
Explain how life annuities address this risk
Why might they be valuable
Why might people not buy them

3. Accumulation: The “First Half” of 401(k) / Retirement Planning
How much money will individuals have at retirement?
Key issues:
Savings rates
Own contributions
Employer match
Investment choices
Administrative expenses

4. Payout: The “Second Half” of Retirement Planning
How do individuals convert their wealth into a sustainable stream of retirement income?
Key Issues:
Longevity risk
Inflation-protection
Spousal protection

5. Payout Period is Lengthening

6. Individuals are Living Longer
Life expectancy at birth in 1900 was only ___ years for men and ___ for women – it has increased approximately ___ years!
Today’s 65-year old man can expect to live to age ___
Today’s 65-year old woman can expect to live to age ___

7. But Uncertainty Remains
Fraction of 65 year olds dying by age 70
Men ____
Women ____
Fraction of 65 year olds living to age 90+ Men ____

8. Your Mortality % Chance of Living to Age …
Males
Females
Age
SSA 50
94.3
97.1 65
84.6
90.4 75
68.8
78.7 90
25.1
39.4
100
3.5
8.4

9. Payout Options Lump sum distribution Systematic withdrawals
Life annuities
Note: All three are covered by minimum distribution requirements

10. Minimum Distribution Requirements
What is Congress’ objective?
Distributions must begin at retirement or April 1 of year after turn 70 (whichever is later)
Acceptable methods
Life annuities that are non-increasing (except for inflation protection)
Payments made based on (IRS) life expectancy
Anything faster is okay
Problems with these rules?

11. Why Does Uncertainty about Length of Life Matter?
Retirement financial planning difficult
Trade-off two risks
Longevity Risk
The risk of outliving one’s resources
Under-Consumption Risk
The risk of dying with substantial wealth that could have been used to finance higher consumption levels while living

12. How Address this Risk? Life Annuities
Trade a stock of wealth for an income stream that cannot be outlived
Solve the consumer’s retirement wealth allocation problem

13. Annuity Provider’s Perspective
Companies can pool and share longevity risk across a large number of individuals
In the United States, the primary provider of annuities is the Social Security system, which pools longevity risk across nearly the entire population

14. Why Are Annuities Valuable?
Individual Perspective
Eliminates risk of outliving one’s resources
Provides higher level of sustainable income that is available without annuities
“Mortality Premium”: the insurer can pay a higher rate of return while living in exchange for loss of principal upon death

15. Example 65 year old male in year 2000 $100,000 of financial wealth
Interest rate = 6%
Inflation = 3%
Compare income from:
Inflation indexed annuity
Nominal annuity
Various “self-annuitization” strategies

17. What is the cost?
What do you give up when you annuitize?

18. Economic Theory
Economic “life-cycle” theory of savings and consumption indicate that annuities ought to be extremely valuable
Simulations indicate that the ability to access annuities is equivalent to a substantial increase in wealth

19. Few 401(k) Plans Offer Annuities
In late 1990s, only about ¼ of plans offered life annuities  even smaller today
Why?
Demand side: workers do not ask for them
Supply side: some fiduciary responsibility for choice of insurer, OR, company carries the longevity risk itself (if set up as trust)

20. Consumer View of Annuities
Lack of consumer understanding
Individuals view annuities as a gamble – what if I die the next day?
They are used to insuring against “bad” events, and living a long time is “good”
Already annuitized by Social Security
Want liquidity for unexpected expenses
Want to leave money to kids
Other?